Prepare Your Brain for the Next Bear Market

Gary Curtis/Alamy
We are again going to experience a market correction or a bear market.

Since 1957, there has been a market correction (defined as a decline of the S&P 500 (^GPSC) by 10 percent or more) every 1.5 years on average. The last correction began in the summer of 2011, when the S&P 500 fell by 19 percent.

Corrections are different from bear markets. Bear markets are defined as market declines of 20 percent or more. Since 1929, there have been 25 bear markets, with the average downturn lasting 10 months. The losses in bear markets during this period ranged from 21 percent to 62 percent, with an average loss of 35 percent. We have had a bear market every 3.4 years. The last bear market ended in March 2009. We are obviously overdue for another one, although no one can reliably predict when it will occur. On average, it takes three years to recover from a bear market.

Now that you know the data, here's the bad news: Unless you prepare your brain for the next bear market, understanding this information will do you no good.

No one has the expertise to predict the next market correction or bear market. If a prediction turns out to be accurate, it should be attributed to luck rather than skill. Keep in mind, however, that those who guess right will almost universally claim it was skill. Relying on the crystal ball of any self-styled market "guru" is not an intelligent or responsible way to invest.

Typical Investor Behavior in Bear Markets

The typical investor buys stocks when the market is going up and sells stocks when the market declines. This is the opposite of rational behavior. When stocks have increased in value, expected returns are lower. Conversely, when stocks have declined in value, expected returns are higher.

Responsible investing involves rebalancing your portfolio when it is not aligned with your optimal asset allocation. This means buying assets that have underperformed and selling assets that have outperformed. Although this strategy is easy to understand, it can be difficult for many investors to overcome the emotional barriers involved with selling assets that have gone up and buying those that have gone down.

Learn from Brain-Impaired Investors

You can learn a lot from a study by researchers from Stanford University, Carnegie Mellon University and the University of Iowa. The researchers analyzed investment decisions made by people whose brains were impaired due to lesions. Their brain impairment related solely to their ability to feel emotions. They had normal IQs, and the parts of their brain responsible for logic and cognitive reasoning were unimpaired.

The participants included these brain-impaired individuals and others who had no brain impairment. Both groups were given the task of completing a gambling-like game, which was designed to reward rational behavior.

The brain-impaired group made the most profitable trades. The "normal" participants were affected by fear and risk-avoiding behavior. They reacted emotionally to early, unfavorable outcomes which clouded their judgment in subsequent trades.

A study co-author theorized that successful investors might be called "functional psychopaths." He meant these individuals were either better at controlling their emotions or didn't let their emotions overcome their ability to logically process information.

You need to start prepping your brain for the next big market decline, because that could be half the battle. You might not like being thought of as a "functioning psychopath," which is pretty strong language. "Successful investor" sounds much better.